Expensive Stocks: All the Profit, Without the High Cost
Our main “The Monthly Income Machine” mission at SaferTrader.com is reliable, significant monthly income no matter which way the market goes… but,
SaferTrader community members do sometimes want to take a “directional” position because they see an opportunity to snag a nice profit on a potential move up (or down) in a particular stock, index, or ETF, i.e. to make an investment for capital gain rather than income.
Once again, the PROPER use of an option strategy will often be far superior to an outright long or short position in a given security, especially if it’s a pricey stock like Google, Apple, Netflix, etc.
A Better Way: How To Multiply Your High Priced Stock Profit Potential Without Increasing Your Risk.
Let’s say you expect a nice up-move in Google during the next couple of months. Most investors looking at options as their vehicle will buy “cheap” out-of-the-money call options to implement their idea.
And, statistically, most of them will lose all or much of their investment because the anticipated move up (1) doesn’t occur and the option expires worthless; or (2) the move up occurs, but too late and the option expires worthless; or (3) the move up occurs, but not enough to make the option profitable at expiration and it expires worthless.
In short, buying an out-of-the-money option is a risky proposition because you are buying the hope that a positive move in the underlying stock or index will occur fast enough, and far enough, to offset the inexorable negative effect of time decay on out-of-the-money options.
In each of the above negative outcomes, the main culprit is the time decay that ALWAYS works against the buyer of out-of-the-money options.
Remember: The value of an option is a function of intrinsic value (how far the option is in-the-money), plus its extrinsic, or “time” value (which reflects how much time remains before option expiration).
Intrinsic Value + Time Value = Option Price (the “premium”)
When one buys an out-of-the-money option, ALL the value is time value (i.e. extrinsic value) because there is no intrinsic value when the price of the underlying stock or index has not moved beyond the option strike price.
But, if we look instead at in-the-money options, especially deep in-the-money options, everything changes for the better!
At first glance they are much more expensive than out-of-the-money options, but that first glance is deceiving. Almost all the price you pay for an in-the-money option is real (intrinsic) value. The value of the option changes pretty much dollar for dollar with the change in value of the underlying security.
The mere passage of time does NOT greatly erode the value of your deep in-the-money option… and that makes all the difference in the world. You will make or lose money on the trade based on whether you are right about direction; time decay doesn’t enter into the matter significantly because you are dealing almost entirely with intrinsic (real) value only.
Consider the following three approaches to investing in expensive XYZ, looking for a move up in the stock. (We’ll ignore commission since it’s a pretty trivial component of the example transactions.)
In each of these examples, assume XYZ is currently trading at 600, and it moves up to 660 over the following two months.
1. Buying the stock.
Assume XYZ is currently at $600.
You buy 100 shares of Google for $60,000.
Two months later XYZ is at $660 and you have a profit of $6,000.
Rate of return on investment = $6,000/$60,000 = 10% in two months.
2. Buying 2 month out-of-the-money call option (strike price 660)
Assume: XYZ is currently at $600.
One XYZ call option (for 100 shares) expiring in 2 months with strike price of 660 costs $580.
You could buy 1 call for $580 (all the value is time value since it’s an out-of-the-money option).
Two months later XYZ is at $660 and your 660 call expires worthless (it only has intrinsic value if XYZ is HIGHER than the strike price at expiration).
Rate of return on investment = none, (a loss of total $580 investment, even though the underlying stock rose 10%).
3. Buying deep in-the-money call option (strike price 550)
Assume: XYZ is currently at $600.
One XYZ call option (for 100 shares) expiring in 2 months with strike price of 550 is trading at 54 and therefore costs $5,400. ($5,000 of this cost is actual (intrinsic) value; only $400 is time value).
Two months later, at expiration of the option, XYZ is at $660, so the 550 call is now trading at 110 and is therefore worth $11,000 on expiration day, reflecting a $5,600 profit.
Rate of return on investment = $5,600/$5,400 = 103.7%
Summarizing: XYZ stock rises from 600 to 660
Buying 100 shares of XYZ stock outright, when trading at $600, costs $60,000 and delivers a $6,000 or 10% return during the 2-month rise of $60/share in XYZ stock. (You could get the nominal return up to 20% if you bought the stock on 50% margin, but you would have had to pay interest on the borrowed funds).
Buying one deep in-the-money (550 strike price) call costs $5,400 and delivers a $5,600 or 103.7% return, based on the same 2 month increase in the price of XYZ stock!
That’s a very big difference, to say the least.
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